Indian real estate: The decade gone by

Before I go down to my thoughts on what the face of real estate in India over the next decade would look like, a bit of post mortem on the decade gone by is important; not only from a perspective creation but also from point of view of understanding the damages, misplaced assumptions can do to a perfectly good industry.

Real estate, owes its status in India as an industry, which incidentally was awarded only around year 1998-2000, to the IT boom and the massive wave of urbanization that we witnessed thereof waking the regulators and legislators to the need of awarding this localized, city specific growth engine oft neglected even by banks both at the developer end as well as end user, industry status. With due regard to their intent ones, they smelled the coffee albeit Rip Van Winkle style, the industry got a few quick doses of capital sources starting with bank finance & mortgages to private equity & Foreign direct investment and finally capital markets, a party that lasted till around 2008-09

The pre-2000 era was marked by a native industry driven by sales driven development model where a developer understood that given the cost and erratic nature of funds for the sector, he has to rely on sales to ensure financial closure of his project. The end user in his turn was conscious that bank finance at 50% of the purchase value at costs north of 18% p.a., was not viable to fulfil is housing dream and hence worked hard to save to buy... average thereby being in mid to late thirties before the first home came by and mostly the last.

Very quickly and thanks to the initiatives by credible banks like ICICI Bank, we saw a frenzied growth in mortgage credit till 2004-2005 and beyond for the end user, giving the buyers a new paradigm to social security in terms of their own roof at costs ranging from early double digits to single digits and quantum close to 80% of value and even so, the mortgage penetration in 2006-2007 was a meagre 7%

Opening up of Venture capital and foreign direct investments in the sector were the game changing paradigms in 2004-05 which were to propel the market in the right direction by providing developers with long term stable capital to perfect their conventional business models and ad sale and size to them... and that was the end of the beginning.

Like all brokerage houses/ bankers/ experts which spit out reports after report of what changes report after report, a habit patterns perfected world over, Real Estate sector fell victim to the same cycle of theoretical excesses in India as well.

A few assumptions that defined this era of frenzied growth and their comic tragedy is enlisted below, not as an afterthought, but as a marked disgust of a cynic seeing it happen

1) Overstated risk weight to a regional player/single segment player in a regional industry forcing him to take the insurmountable risk of going pan-national & multi asset portfolioReal Estate is a local subject matter right from regulations to sales. Everyone in his conventional wisdom thrived by perfecting the art to a local science, be it DLF & Unitech in Delhi NCR or a Raheja & Oberoi in Mumbai or even a Prestige & Purvankara in Bangalore.

In came our bankers ascribing a high geographical concentration risk to a successful business model and drove the capital starved developer to a pan national footprint in the hope of encashing the dollars promised. We know now, that those who survived were those who either did not follow the pied piper or were quick to change course realizing the futility of this madness.

The madness did not end in term of geographical diversification as a risk enhancing risk mitigant, it extended to sectoral exposures as well. Hence, if you did only residential you were high risk, so the need to do hospitality, commercial, retail and what not, for a well balanced portfolio. Really, I mean was this happening.

You were asking a sane developer to give up his native de-leveraged, sales driven, price discovered strategy for an asset heavy, illiquid, debt funded, services driven asset ownership plan! How was he to fund it all? Who was going to buy it from him? How would he know how a a services business like hospitality or retail make money? Never mind, it was still diversification and the proverbial pot of gold lay in diversification and hence went the sensible following the piped dream of greed!

2) Power of technology, when forsaken as an enabler and treated as an end to itself! Excel driven investingThe fundamental premise of Real Estate being a cash flow driven business and not a profit maximizing business emanated from local nuances, including but not limited to lack of cheap & long term credit, absence of sophisticated alternatives for exit in the form of REIT markets and an even stringent offshore policy dis-allowing foreign capital to buy ready stock.

In such a market, complicated excel sheets, far away from drivers on ground, propagated a set of arguably unreasonable propositions. These included among others, the fact that if you help on to your prices or even increased them, irrespective of what you sold, your valuation should be higher. Further, constructing with debt is a better way to ensure maximum realization per square feet because prices follow a time continuum independent of progress on ground. If costs escalate by 5%, given the demand supply situation prices will appreciate by 8%, hence on paper you never lose money, how bizarre?

Anyways all these excesses took a toll on perfectly executable projects by rendering them unaffordable and hence undeliverable. Add to this the grandiose belief that if the number in millions can fit in the excel cell, it can be delivered on ground at exactly the same cost as thought you were delivering 1/100th of the stock.

A virtuous cycle of sales driven projects was now replaced by a vicious cycle of debt driven development and the rest is history!

3) Capital markets, the panacea for dreams or a malady for all glooms?And no matter what you do, if the price growth is sustained and you can show longevity of a 100 years through accumulation of a land bank, no matter where, and show a portfolio across real estate segments, the market will reward you! Indeed, valuations were driven by land banks with no regard to their executability. In fact, cheaper the land, hence by corollary far away from economic hubs, the better the value, since whether a road reached your land or not, the customer surely will and pay you in Patna what is a fair price in Pune! Really! Thankfully this madness did not last long! And soon the markets corrected its insanity. But not before driving the bred of successful developers who had survived decades on the brink of bankruptcy & value erosion in a short span of 3 years.

And look, how the saintly banker now looks at them as a victim when he was in fact the perpetrator of this madness! The seriousness with which I hear investors say, “We will wait to invest in India again till such time we see our monies come back” sounds quizzically funny! As though someone has a magic wand or a genie to pay for their theoretical assumptions of growth, bereft of substance, even a visit to the country where billions got pumped basis assumptions of how the market may have worked in the western world! I am by no means making a villain out of the investor, but at the same time the unwanted and overtly hypocritical view that developers by and large systematically robbed the investors of their fair share is equally preposterous. I don’t deny a few bad apples but, for most, they were equally a victim of their ignorance of the savvy financial markets as the savvy financial markets were a victim of their ignorance of the native real estate market.

The world was a different place post the Lehman crisis, a bit solemn I could add with a touch of irony! Suddenly, the money bags who promised the moon the earthly developer had vanished for all the wrong assumptions he had heaped on the industry for its cardinal sin of having accepted them! He still emerged saviour to a cash strapped, debt laden, valuation derived, and illiquid industry. But this time, wanted 21% IRRs net of tax which is around 30% project level returns to say the least, with a 2 time asset cover and the soul of the partner as collateral to bail him out of the immediate crisis. All in the name of risk mitigation.

Think about it! An illiquid, sales bereft, execution limited, stretched industry needs capital to restore the capital cycle! And you ask them in lieu of investment, to pay a monthly coupon of 30% pre –tax from sales before a penny goes to construction! And at the same time, expect the market to revive and the developer to pay? Well, the truth is, he will not be able to even if he wanted! And sure, he will still take the money because he is looking at short term survival! Alas! He still is the villain because he did not honour his commitment! Does it not sound a bit strange?

Come 2011-15, the romance with global capital to rebuild our cities was a distant dream, replaced by the Shylocks of Venice! The industry went through a stage of self introspection, most players who still had it, returned home to their core markets and segments and to the good old delivery driven sales oriented model to come out of the quagmire even as multitudes around them failed.

The regulators joined the party with innovative ways to delay projects be it on the pretext of corruption or environment and together came the proposed real estate regulatory bill, that plans to jail the developer for non-delivery with no mention to the fact that the largest culprit in delays, the sanctioning process so well governed by the multi layered regulators is at the root of this bane!

Debt overburden, lack of long term patient capital, delayed approvals and shrinking investor confidence later, clearly a visible supply overhang, a lot of it under-development still and hence not supply in the strictest sense, prices beyond the glass ceiling of this price sensitive nation... not by 50% but more like a 10-15% hence within striking range, we have even fancier reports that talk of 50% price declines, more to match rental yields then the underlying demand, basis fancy mathematical derivations of how things work globally with no regard of local conditions continue to queer the pitch of a whimsical market.

DISCLAIMER: The views expressed are solely of the author and ETRealty.com does not necessarily subscribe to it. ETRealty.com shall not be responsible for any damage caused to any person/organisation directly or indirectly.